Four Years and Counting for California

It has been nearly six years since the end of the nationwide recession that started on the heels of the financial crisis. California’s fiscal woes that resulted from a 15% slowdown in tax receipts in 2007-2008 now seem like a distant memory. The state has finally balanced its budget and the San Francisco Bay Area and much of urban California are booming due to job and wealth creation. Unemployment has improved dramatically from its high of over 12% in 2010 to the current level of 6.5%. Housing prices in urban areas have reached new highs, pushing rents up too. Unfortunately, the gains have been uneven, with rural California still feeling the pinch of slow growth and disappointing employment opportunities.

Californians seem to be accustomed to dealing with the booms and busts of the state’s economy. In the last 40 years, the declining defense industry, bursting technology bubble, rolling energy brownouts and a frightening financial crisis were overcome. California is one of the 10 largest economies in the world by gross domestic product.

Now California is facing off against Mother Nature. With seas rising, we have plenty of water, but four years of drought in many parts of the western states have dramatically reduced the fresh water we need for our homes and farms. As a result, the realities of rationing are likely to become a part of our lives for years to come.

According to a recent U.S. census, California has a population of 38 million residents, with the vast majority living in urban areas. The California Department of Finance projects an increase in population to 52.6 million by 2060, a slower pace of growth than what California experienced prior to the financial crisis but a slightly faster rate than the country as a whole. To accommodate this growth, the state will need to address the allocation of water aggressively. The Public Policy Institute of California reports that urban dwellers use roughly 20% of the state’s water, with agriculture accounting for the remaining 80% of consumption.

With that water, California’s farmers provide nearly half of our country’s produce. With consumers becoming ever more discerning about food and demanding more fresh, locally-grown produce, a commitment to agriculture seems as Californian as redwood trees and sunshine. According to the U.S. Department of Agriculture (USDA), California is the number one U.S. state exporter of fruits, nuts, vegetables and dairy – accounting for $22 billion in revenues. As large as this number is, agriculture represents a surprisingly meager 1.2% of California’s GDP. In 2007, agriculture accounted for only 5% of the state’s employment. That figure is declining as land is fallowed and workers are laid off because of the drought. California’s farmers have already paid a steep price for the reduction in available water. A U.C. Davis study estimated losses of $1.5 billion for the agricultural industry in 2014 due to fallow farm land, reduced dairy production and the increased cost of sourcing water.

California’s farms are highly productive, benefitting from good soil, a long growing season and extensive irrigation. Without irrigation, most crops could not grow here; in fact, California Indians had almost no agriculture. Expensive systems have been developed to supply the state’s extensive irrigation needs. The U.C. Davis study projected that groundwater usage would represent roughly 55% of the resources used by California farmers in 2014, an increase from an average of 31% reliance on aquifers in the past. As groundwater reserves are depleted, many sink or collapse, never to be filled again, leaving thousands in farming communities without running water.

Urban consumers will also have to grapple with water conservation. According to the California Department of Water Resources, half of the state’s gross urban water usage is for landscaping. Consumers in San Diego County use 150 gallons of water a day. In Sydney, Australia, people use about half that amount despite a similar climate and level of wealth, according to David Zetland, author of Living with Water Scarcity. To cope with this, Governor Brown recently mandated a 25% water usage reduction throughout the state, to be achieved by specific cut-backs assigned to local water agencies. Of note, Palm Springs residents use up to 200 gallons of water each day, nearly twice the state average, and are now required to cut water usage by 50%. Farms are not included in this initial round of cuts since most are already receiving minimal allocations from major water projects.

It seems that any effective long-term solution will include higher prices for water. At present, water remains quite cheap, even after four years of drought.

Per our family’s most recent water bill, we are paying less than one half of one cent for every incremental gallon we use. Put another way, 100 gallons of water only cost us about 40 cents. At these rates, households have little economic incentive to conserve. Many water companies have already implemented some form of tiered rate system (higher rates for usage in excess of certain thresholds) and this trend will continue. Within these tiered systems, expect water companies to increase the rates for usage significantly in excess of baseline levels.

When resources are scarce, investment opportunities can emerge. Research into desalination and improved irrigation technologies are likely to increase as California’s drought intensifies, but that doesn’t mean that these opportunities will be easy to identify or profitable for investors. There are funds constructed to provide exposure to the water industry, focusing on both the U.S. and global markets. The Powershares Water Resources Portfolio (ticker PHO) holds established U.S. companies involved in the water industry. The positions are concentrated in technology and materials companies with a portion of revenues from water-related products. Utilities that deliver water are also included, but many have limited profitability due to regulation. This fund has underperformed the Standard & Poor’s 500 by an average of 6.3% per year for the five years ended March 31, 2015.

Given underlying demographic trends and the role agriculture plays in the state, California’s long-term water problems are not going away even if the rains return and the current drought ends. The state has an opportunity to use this current crisis to begin shifting its mindset from the assumption that plentiful, cheap water will always be available. Unfortunately, this problem can’t be fixed by the stroke of a governor’s pen. The most economical fix will come from Mother Nature by way of precipitation, and lots of it. Like rolling brown-outs and the budget crisis, perhaps she will see to it that this, too, shall pass.